The stock market is up over 40% from the March 23 bottom. This spectacular 50-day rise bookends the 33% market drop from mid-February to the March bottom. Overall, the S&P 500 moved by more than 70% in a little over three months, leaving many investors bewildered. But recent market action implies that most traders are expecting conditions to improve from here. Stimulus measures, reopening the economy, and hopes for a virus vaccine or treatment are all part of the recovery scenario. In this week’s commentary, we look at what is driving the case for both bears and bulls. We also discuss portfolio implications of the rising prevalence of “zombie” firms in the market.

But even though stocks seem to be forecasting recovery, we will not be throwing caution to the wind. A heightened focus on financially strong companies remains essential because profits and dividends are under pressure, and more firms carry higher debt loads today than in the past.

Profit and Dividend Contraction

According to FactSet Research, analysts expect S&P 500 profits to fall 43% in the second quarter. For the full year, expectations are for a 23% drop in profits. This decline also exposes some companies to dividend cuts. While it is impossible to predict which companies will cut, there are some tendencies worth noting.

Dividends tend to be “stickier” than earnings. So, we expect S&P 500 dividends to decline, but by only about 10-15%. Share buybacks can be suspended and restarted without much notice, and companies are more likely to curtail buyback programs before cutting dividends whenever possible. Hence, we envision larger cuts in share buyback programs than in dividends.

While it is impossible to predict which companies will cut or eliminate a dividend, we find that other factors can increase the odds of a dividend cut when profits come under pressure.

We find that firms with these characteristics can be far more likely to cut a dividend:

  1. below average profitability (income/assets)
  2. above average leverage (debt/capital)
  3. above average payout ratios (dividends/earnings)
  4. and above-average dividend yield (dividend/price)

During the 2007-2009 recession, far more dividend cutters fit the profile above. 40% of companies with the above characteristics at the end of 2007 cut dividends — twice the average rate for the overall market. Unprofitable, highly-indebted, high-yielding companies with poor dividend coverage are less likely to maintain dividends when the going gets tough. Dividend cutters also tend to generate lower total returns over time versus companies that raise or maintain dividends (Case for Rising Dividends).

Thus, when profits are receding, as is the case today, it is even more important to focus on companies with a high degree of financial flexibility.

Rising Debt and “Zombies”

It has been easy to pick winners during the past 50 days because every stock in the S&P 500 is up over that period. Unfortunately, this happy scenario is not likely to continue. It is far more likely, in our view, that the market begins a deliberate sorting-out process. Companies that need continuous debt financing or bailouts to operate are likely to be penalized in this process. These businesses should be avoided, especially if recovery is slower than expected, credit availability tightens, or interest costs rise. We think self-funding, conservatively financed, cash-rich businesses will fare better.

To wit, a growing percentage of companies are unable to cover interest costs from profits. More and more of these firms’ resources are absorbed in debt service and diverted away from productive investment and growth that drives long-run shareholder value. A 2018 study by the Bank of International Settlements labeled such firms “zombies.” These firms can remain in business for years but in a weakened state and dependent on easy credit access. According to the study, 16% of U.S. public firms are “zombies” today compared to 2% during the late 1980s. In a hyper-competitive world, “zombies” are vulnerable to challenges by younger, more financially nimble competitors. These firms often carry higher dividend yields but tend to carry higher risk and/or lower growth.

A decade of cheap financing contributed to conditions that created rising indebtedness. The result has been a rising debt service burden and a lessening of credit quality. The average ratio of net debt (debt-cash) to cash flow for the 3,000 largest public U.S. stocks has risen to 2.7x from 1.0x in 2007. Higher indebtedness can lead to greater losses for shareholders when business conditions falter.

Conclusion

So it is clear that while stocks are on a tear, we should continue to focus on reliable and financially flexible companies for two main reasons. First, we should keep the focus because declining profits make dividend cuts far more likely for weak and leveraged firms. But most importantly, because a decade of easy monetary conditions has left many firms with high debts and weakened balance sheets.

And what if we are wrong and things recover faster and more completely than we currently expect? In that case, the bull run might run further and farther than we now expect. If that happens, we will take comfort in knowing that Washington Crossing’s portfolios are invested in the highest quality businesses we can find at valuations we find to be reasonable.

Disclosures:

WCA Barometer – We regularly assess changes in fundamental conditions to help guide near-term asset allocation decisions. Analysis incorporates approximately 30 forward-looking indicators in categories ranging from Credit and Capital Markets to U.S. Economic Conditions and Foreign Conditions. From each category of data, we create three diffusion-style sub-indices that measure the trends in the underlying data. Sustained improvement that is spread across a wide variety of observations will produce index readings above 50 (potentially favoring stocks), while readings below 50 would indicate potential deterioration (potentially favoring bonds). The WCA Fundamental Conditions Index combines the three underlying categories into a single summary measure. This measure can be thought of as a “barometer” for changes in fundamental conditions.

Standard & Poor’s 500 Index (S&P 500) is a capitalization-weighted index that is generally considered representative of the U.S. large capitalization market.

S&P Global (SPGI) is a leading American provider of financial information, analytics, and credit ratings, headquartered in New York, NY. It operates major divisions including S&P Global Ratings, S&P Global Market Intelligence, S&P Global Commodity Insights, S&P Global Mobility, and S&P Dow Jones Indices.

The ICE BofA U.S. High Yield Index is an unmanaged index that tracks the performance of U.S. dollar denominated, below investment-grade rated corporate debt publicly issued in the U.S. domestic market.

The S&P 500 Growth measures constituents from the S&P 500 that are classified as growth stocks based on three factors: sales growth, the ratio of earnings change to price, and momentum.

The S&P 500 Value Index measures constituents from the S&P 500 that are classified as value stocks based on three factors: the ratios of book value, earnings and sales to price.

The S&P 500 Equal Weight Index is the equal-weight version of the widely regarded Standard & Poor’s 500 Index, which is generally considered representative of the U.S. large capitalization market. The index has the same constituents as the capitalization-weighted S&P 500, but each company in the index is allocated a fixed weight of 0.20% at each quarterly rebalancing.

The WCA Rising Dividend Custom Benchmark is a rules-based benchmark constructed by Washington Crossing Advisors to represent a universe of large capitalization U.S. companies that meet certain quality and dividend growth criteria, including proprietary screens for profitability, earnings consistency, and balance sheet strength, along with minimum market capitalization and dividend growth requirements. The benchmark is reconstituted and rebalanced quarterly and is intended to serve as a style-appropriate benchmark for the WCA Rising Dividend strategy.

The Washington Crossing Advisors’ High Quality Index and Low Quality Index are objective, quantitative measures designed to identify quality in the top 1,000 U.S. companies. Ranked by fundamental factors, WCA grades companies from “A” (top quintile) to “F” (bottom quintile). Factors include debt relative to equity, asset profitability, and consistency in performance. Companies with lower debt, higher profitability, and greater consistency earn higher grades. These indices are reconstituted annually and rebalanced daily. For informational purposes only, and WCA Quality Grade indices do not reflect the performance of any WCA investment strategy.

The risk of loss in trading commodities and futures can be substantial. You should therefore carefully consider whether such trading is suitable for you in light of your financial condition. The high degree of leverage that is often obtainable in commodity trading can work against you as well as for you. The use of leverage can lead to large losses as well as gains.

The information contained herein has been prepared from sources believed to be reliable but is not guaranteed by us and is not a complete summary or statement of all available data, nor is it considered an offer to buy or sell any securities referred to herein. Opinions expressed are subject to change without notice and do not take into account the particular investment objectives, financial situation, or needs of individual investors. There is no guarantee that the figures or opinions forecast in this report will be realized or achieved. Employees of Stifel, Nicolaus & Company, Incorporated or its affiliates may, at times, release written or oral commentary, technical analysis, or trading strategies that differ from the opinions expressed within. Past performance is no guarantee of future results. Indices are unmanaged, and you cannot invest directly in an index.

Asset allocation and diversification do not ensure a profit and may not protect against loss. There are special considerations associated with international investing, including the risk of currency fluctuations and political and economic events. Changes in market conditions or a company’s financial condition may impact a company’s ability to continue to pay dividends, and companies may also choose to discontinue dividend payments. Investing in emerging markets may involve greater risk and volatility than investing in more developed countries. Due to their narrow focus, sector-based investments typically exhibit greater volatility. Small-company stocks are typically more volatile and carry additional risks since smaller companies generally are not as well established as larger companies. Property values can fall due to environmental, economic, or other reasons, and changes in interest rates can negatively impact the performance of real estate companies. When investing in bonds, it is important to note that as interest rates rise, bond prices will fall. High-yield bonds have greater credit risk than higher-quality bonds. Bond laddering does not assure a profit or protect against loss in a declining market. The risk of loss in trading commodities and futures can be substantial. You should therefore carefully consider whether such trading is suitable for you in light of your financial condition. The high degree of leverage that is often obtainable in commodity trading can work against you as well as for you. The use of leverage can lead to large losses as well as gains. Changes in market conditions or a company’s financial condition may impact a company’s ability to continue to pay dividends, and companies may also choose to discontinue dividend payments.

All investments involve risk, including loss of principal, and there is no guarantee that investment objectives will be met. It is important to review your investment objectives, risk tolerance, and liquidity needs before choosing an investment style or manager. Equity investments are subject generally to market, market sector, market liquidity, issuer, and investment style risks, among other factors to varying degrees. Fixed Income investments are subject to market, market liquidity, issuer, investment style, interest rate, credit quality, and call risks, among other factors to varying degrees.

Beta is a measure of the volatility, or systematic risk, of a security or a portfolio relative to the market as a whole. A beta of one is considered as risky as the benchmark and is therefore likely to provide expected returns approximate to those of the benchmark during both up and down periods. A portfolio with a beta of two would move approximately twice as much as the benchmark.

Standard deviation is a measure of the volatility of a security’s or portfolio’s returns in relation to the mean return. The larger the standard deviation, the greater the volatility of return in relation to the mean return.

Changes in market conditions or a company’s financial condition may impact a company’s ability to continue to pay dividends, and companies may also choose to discontinue dividend payments

This commentary often expresses opinions about the direction of market, investment sector, and other trends. The opinions should not be considered predictions of future results. The information contained in this report is based on sources believed to be reliable, but is not guaranteed and not necessarily complete.

The securities discussed in this material were selected due to recent changes in the strategies. This selection criterion is not based on any measurement of performance of the underlying security.

Washington Crossing Advisors, LLC is a wholly-owned subsidiary and affiliated SEC Registered Investment Adviser of Stifel Financial Corp (NYSE: SF). Registration with the SEC implies no level of sophistication in investment management.